What makes an individual an effective director of a Fortune 500 company? Is it skills, experience, and connections? Or is it outside allegiances that pull a director one way or another? Are women better at it than men? Do executives from other companies have an edge?
A group of researchers including W. P. Carey School of Business experts sought answers to these and related questions through an exhaustive and detailed analysis of the voting records of shareholders of major U.S. corporations. The team studied the results of elections of over 2,000 Fortune 500 directors in 2006 and developed insights into ways to promote effective corporate governance. The findings also shed light on the two major academic theories used by researchers in the field.
Andthis project was not simply an academic exercise. Corporate responsibility, director accountability, and shareholder activism have been major issues for business, finance, and government since the Enron, WorldCom, and other scandals broke about five years ago.
"We want to know what makes a director a better choice than another potential candidate," said Amy Hillman, professor of management and executive dean at the W. P. Carey School. "We're concerned with things like how willing they are to question management, how willing they are to weigh in with their own expertise, and call in their connections to help the firm."
Measuring effectiveness: shareholder votes
Earlier academic studies on this topic usually looked for correlations between the attributes of directors and the performance of firms. The problem with this approach is that there are so many other variables that affect firm performance -- from industry-wide changes to upheaval in the competitive environment -- that conclusions are hard to come by. Indeed, this research has not identified many traits of directors that can be linked to how well a firm is doing.
For this project, the researchers decided instead to examine how often shareholders withheld votes from directors in board elections. Voting shareholders, almost all of whom represent institutional investors and other analysts who follow corporations closely, provide a valuable source of knowledge about the effectiveness of directors, according to the study, entitled, "What I Like About You: Director Characteristics and Shareholder Approval," co-authored by Hillman and S. Trevis Certo of W. P. Carey, Christine Shropshire of the University of Georgia and Dan R. Dalton and Catherine M. Dalton of Indiana University.
"Although shareholder elections of directors have received little attention from scholars, anecdotal observation reveals that some directors are elected to the board with near unanimous support, while others receive clear signals of investor displeasure through a significant number of votes withheld," the authors state.
Analyzing previously unavailable data on director elections which was collected recently by the Institute for Corporate Governance at Indiana's Kelley School of Business, the researchers made some important discoveries about what shareholders value in a director.
While female directors are rare, they appear to be highly valued. The data show that shareholders are less likely to withhold votes for female directors than male directors. The researchers hypothesize that shareholders value women because they are especially effective at linking a firm to key stakeholders, including employees, customers, and groups outside the company.
As companies consider bringing more women onto boards, this finding could be very important, according to Hillman. "It is the first real evidence I've seen that this idea of diverse boards is good and that having different perspectives is a good thing," she said. "It looks like if you're running for a board seat you're going to have an advantage if you're a female."
The results contradict a widely held belief in the corporate world that being an executive in another firm is a highly prized qualification for a director. In fact, outside executives were neither more nor less likely to be favored by shareholders in director elections, according to the study.
Hillman said this is somewhat surprising, since "that's the traditional career path for directors -- to be an active or a retired CEO in another firm."
The researchers found that directors who were new to a board and those who had been on for a very long time were less likely to receive votes than directors who had held the position for a moderate length of time.
"They didn't want a brand new rookie and they didn't want someone that would be perceived as stale in the saddle," said Hillman. "They were looking for a director who was somewhere in the middle."
Testing the theories
The researchers developed a series of hypotheses to test with the data on director votes. They formulated the hypotheses using the two predominant theories in the field of corporate governance study -- agency theory and resource dependence.
Widely used by researchers in law, finance, and management, the agency theory holds that the potential for directors and shareholders to have divergent interests is the key to understanding the effectiveness of directors. For example, agency theory predicts that directors who come from outside a company will be more likely to monitor management than directors who are insiders.
Resource dependence theory focuses on the ability of directors to bring resources to a firm. It holds that directors who succeed are those who can lend prestige to a company, provide expert advice, or help with connections to key people and organizations on the outside.
In some cases, agency theory and resource dependence theory come up with contradictory conclusions. For example, resource dependence theory holds that directors who are affiliated with the firm will be an asset to a firm because research shows CEOs are more likely to solicit and take advice from those they are tied to socially or professionally, while agency theory predicts that such affiliation will render them less effective.
Their research shows that affiliated directors are penalized by shareholders, supporting the agency theory line of logic.
The study did support one widely held assumption, which also is predicted by both of the major theories: Shareholders are unhappy with executive pay. The researchers hypothesized that membership on the compensation committee of a board would lead to fewer votes for a director up for election. Indeed, that was the case.
"Shareholders are looking for pay and performance to be more closely coupled for CEOs," said Shropshire. The researchers concluded that the two theories are both useful, but neither is sufficient on its own. "We're hoping this will promote more multi-theoretical research," Shropshire said.
Said Hillman, "One of the things this study suggests is that you can't just use one in isolation from the other. You need to take into account both. It's not only a director's ability to do their job but their incentive and motivation to do their job."
- What makes a good director of a company is an important question that has occupied scholars for decades. Interest has grown in recent years following corporate scandals that appear to have been the result of weak oversight.
- A shareholder who withholds a vote for a director is signaling dissatisfaction with the director's performance. Analyzing the characteristics of directors and whether they have had votes withheld can provide clues to who is likely to be effective in the position.
- Diversity is a virtue to shareholders, at least in the case of women on boards. The study found that shareholders are less likely to withhold votes for women than men.
- Executive pay remains a concern for shareholders, and they hold directors responsible. Directors who serve on compensation committees of boards are more likely to have votes withheld than those who don't serve on the committees.